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Hardship Withdrawal

An urgent removal of funds from a retirement plan and is usually done in emergency situations

What is a Hardship Withdrawal?

A hardship withdrawal is an urgent removal of funds from a retirement plan and is usually done in emergency situations. Conducting a hardship withdrawal is considered a “special distribution,” which is exempt from any sort of financial repercussions if the withdrawal meets specific criteria.

 

Hardship Withdrawal

 

Due to immediate need, a hardship withdrawal is usually done without a credit check.

An individual cannot withdraw in excess of their financial burden. The U.S. Internal Revenue Service (IRS) states that such withdrawal is done for “immediate and heavy financial need.”

 

How to Avoid Penalties

In the most basic sense, 10% penalties are given to individuals who take out hardship withdrawals if they are under the age of 59.5. In some conditions, the penalties can be bypassed through specific rules and criteria.

The specified rules and criteria apply to different aspects of a financial burden and will cover medical expenses, university expenses, health insurance, and first-time homebuyers.

 

1. Medical expenses

If an individual is taking out a hardship withdrawal to cover medical expenses, they may avoid the penalty if the unreimbursed qualified medical expense does not exceed 10% of your adjusted gross income.

 

2. University expenses

Hardship withdrawal penalties can be avoided by allocating the money to qualified university expenses such as tuition, books, and board. Additionally, the withdrawal can be used for non-arm’s length university expenses only if they are attending school half time.

 

3. Health insurance

In terms of health insurance, an individual may avoid the hardship withdrawal penalty if they’ve been unemployed for at least 12 weeks and use the compensation to pay for health insurance premiums.

 

4. First-time homebuyers

First-time homeowners are able to evade the hardship withdrawal penalty only if they have not owned another home in the last two years. Additionally, the withdrawal cannot exceed $10,000 and must only be allocated to the down payment.

 

Advantages of a Hardship Withdrawal

In a time of financial distress and need, proceeding with a hardship withdrawal can be a financial self-preservation saving strategy. Listed below are the advantages of taking out a hardship withdrawal:

  • It provides immediate financial relief.
  • It reduces financial stress, anxiety, and worry.
  • The funds can be distributed quickly, without a background check.
  • Individuals can access funding for legitimate purposes, such as medical expenses, university tuition, and housing costs.

It should be emphasized that a hardship withdrawal should only be done in situations where there is no other option present. This is because there are a number of long-lasting tax implications that may be felt by the individual.

 

Disadvantages of a Hardship Withdrawal

Although a hardship withdrawal is requested in a time of need, the lasting disadvantages should be considered before a decision is made. Listed below are the disadvantages of taking out a hardship withdrawal:

  • Individuals who proceed with a hardship withdrawal are required to suspend deferrals six months afterwards.
  • The amount that is withdrawn cannot be repaid back into the plan.
  • Hardship withdrawals are subject to income tax and will be reported on the individual’s taxable income for the year.
  • If the individual is below 59 years old, they may be required to pay a 10% penalty.
  • Loss of compounding interest on the amount that was withdrawn.

Even though hardship withdrawals are done in undesirable but unavoidable situations, an individual should evaluate the disadvantages thoroughly so that the long-lasting effects are fully understood.

 

Hardship Withdrawal Alternatives

Rather than relying on a hardship withdrawal as a last-ditch effort to repay some sort of expense, it may be beneficial to consider alternatives that offer better recourse. Discussed below are the assortment of other options that should be evaluated before making the decision to use a hardship withdrawal.

Payment Plan: By contacting a personal care provider, there may be an option to arrange a reasonable payment schedule that is advantageous to the expense.

Government Benefits: Government benefits can pay for certain expenses such as housing, food, education, and health care. Find out if you, or any loved ones, qualify for this benefit.

Personal Loan: Rather than going to a financial institution, approach one of your family members, friends, or colleagues to arrange a personal loan.

Credit Card: If the emergency is short-term and financially small, the best option would be to incur credit card debt rather than touching a retirement account.

401(k) Loan: 401(k) plans offer a withdrawal option that reduces an individual’s paycheck and retirement savings. However, they do not affect the individual’s credit rating and are not immediately taxable unless an individual leaves their occupation.

401(k) After-Tax Funds: In some instances, there may be after-tax funds in an individual’s 401(k). To confirm this, contact your plan administrator.

Choosing to use a hardship withdrawal in a time of need comes with an assortment of long-lasting negative tax implications that can be avoided by selecting one of the options above.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

  • 401(k) Loan
  • Frictional Unemployment
  • Modified Adjusted Gross Income (MAGI)
  • Taxable Income

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!